Who “owns” a business? How are businesses structured?
As described under Startup, there are several ways to organize a business, such as a corporation, a limited liability company and a limited partnership (for certain real estate ventures); or the less popular sole proprietorship, general partnerships, and limited liability partnerships.
Normally, the “owners” of a business are the individuals or entities that own equity in the business. These are called “stockholders” or “shareholders” for corporations, “members” for limited liability companies, and “partners” (especially “limited partners”) for limited partnerships. The easiest way to see this ownership at work is to consider what happens to these people were the business to be wound up and liquidated: after all creditors are satisfied and debts paid off, the equity holders get everything that is left over—generally their “pro rata” share.
A corporation may have one or many types of stockholders. There are always “common” stockholders; initially, these will be the founders and any additional early-stage investors, like angel investors. A corporation can also have classes of preferred stock, which is how venture capital firms make their investments. Preferred stock generally has precedence over the common stock in terms of getting paid if the company is sold or liquidated. While preferred stockholders are generally more “passive investors” than common stockholders in a startup company, it is not unusual for the preferred stockholders, or even different series of preferred stockholders, to get to elect their own directors.
The business and affairs of a corporation are managed by or under a board of directors. The stockholders elect the directors, who may or may not be stockholders in the company themselves. The board comes up with the “big picture” strategic decisions for the corporation, including the election of officers. Importantly, state law imposes certain fiduciary duties on directors; simply put they must act prudently and in the best interests of the corporation and its stockholders.
Officers, such as the CEO, president, and treasurer, are elected by the board of directors and are responsible for the day-to-day operation of the corporation. Again, officers may or may not be stockholders of the company. Officers who are not otherwise founders of or investors in the company may receive stock options as part of their compensation.
It is common in a startup company for the same person or group of people to serve in all three of these positions – stockholder, director and officer. For example, someone founds a company and is its sole stockholder, elects herself to be the sole director of the company, and then appoints herself as the President and CEO. This could potentially lead to problems though; if a sole stockholder/director/officer doesn’t observe all of the formalities of a corporation and treats the entity as a mere “alter ego,” a court could “pierce the corporate veil” and hold the stockholder liable. Doing so is an exceptional remedy from the courts, as it disregards the limited liability that is the purpose of forming a business entity in the first place, but it is possible in extreme cases. As the company grows and there are more stockholders, the board usually grows as well, with the founder having less overall control than she had at the beginning.
A limited liability company is more flexible than a corporation, but it is not uncommon for them to be structured similarly to a corporation. That is, the members of the LLC are generally passive, electing a board of managers to do the heavy lifting. Doing so is convenient for when an LLC is taking in some passive investment. Additionally, the managers may have some more freedom in their management of an LLC; it may be possible to restrict or eliminate the fiduciary duties imposed on the directors of the corporation.
A limited liability company can also be directly managed by its members, if that’s what the members want when establishing the LLC. This is much more common among startups that do not have and do not anticipating having any passive investment. It would have a similar result as the sole stockholder/sole director/CEO example of a corporation above, but with fewer formalities to observe.
A limited partnership, which again is useful only for certain types of real estate ventures, has one or more general partners who are responsible for the management of the partnership and shoulder all of the partnerships liabilities, and one or more limited partners who are passive investors.